Manual:$wgHashedUploadDirectory

Details
If, uploaded files will be distributed into sub-directories of $wgUploadDirectory based on the first two characters of the md5 hash of the filename. (e.g. ) Creation of such subdirectories is handled automatically. This is used to avoid having too many files in one folder because some filesystems don't perform well with large numbers of files in one folder.

The algorithm for that is based on a md5 of the name, the first hex character is used for the first directory, then the first two characters are used for the subdirectory. Foo.png -> md5 = f865cbca12286c1c5b7616b4a70fbf68 -> f + f8 = $IP/images/f/f8/Foo.png

If, all images are uploaded in $wgUploadDirectory itself. (e.g. )