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 (or is it in fact based on filename and path? Also fix example in next paragraph accordingly!). (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.
 * → md5 of filename =  → f + f8 = $IP/images/f/f8/Foo.png

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

If you set, this variable will be ignored.