Spatial sound is used when your Windows sound setting has a Spatial Sound mode enabled. This includes Dolby Atmos, or DTS:X format. Spatial Sound is different from surround sound as it uses “object” based sound placement, instead of sound “channels” where Stereo, 5.1, and 7.1 is the most common audio “channel” format. The conventional channels only give you 2-dimensional sound around you.
Spatial Sound like Dolby Atmos, however can replicate sounds in a 3-D space. Meaning you can also hear sounds from above you or below you. You need a compatible sound system for this, though. If you use a Dolby Atmos enabled sound system, you can enable the Dolby Atmos spatial sound mode in Windows for free. But if you only have a headphone, you need to purchase a license to use the Dolby Atmos for Headphones format.
Either way, once you have this enabled in Windows, MSFS can utilise this Spatial Sound mode and apply the object based audio format into your flights. Without a proper sound system that supports it or if your Windows doesn’t have it enabled, turning on Spatial Sound in MSFS won’t do anything, since you’ll be hearing from the same sound sources as before with it off.