Even modern fast CPUs struggle to decode HD video in real time, so modern graphics cards have the ability to do it instead. Graphics processors, or GPUs, have many times more cores than CPUs, but they're a lot simpler. This means they're better suited to drawing video or 3d scenes, where it's usually possible to divide the picture up into pieces that can be processed in parallel. The RPI has a really slow processor, so is even less capable of decoding video itself, known as 'software rendering'. Luckily, because its chip is intended for video oriented set top boxes, it contains a decent GPU that is capable of decoding HD video in the three main video formats used today. However, as rcxdude mentioned, those decoding algorithms are not free, and is controlled with a license key. Vlc has no access to this video decoding hardware if it's locked, so must use the CPU.

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That's painfully inadequate on the pi. To expand on the price point: The Raspberry Pi foundation could have opted for a volume license for all Raspberry Pi devices to be licensed from the get go. However while this is fine for Microsoft and the like, it would have gone easily into the multi-thousand-pound range as all they can give is estimated sales and that would have pushed up prices of the unit itself. Considering how cheap it is for individual licenses and the very tinkerer nature of RPi itself, it made more sense to ask users to purchase single device licenses, install them manually and probably save everyone some money overall. To expand on the 'what is it' point: What you're buying is a license key that the codec itself requires be present before accepting or working on any audio or video stream sent to it.

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I believe the codec is part of most distros as it's just a few Kb, but without licensing it's essentially useless.