What does Chrome's "Incognito Mode" do exactly?

It essentially sets the cache path to a temporary folder. Cookies are still used, but everything starts "fresh" when the incognito window is launched. This applies all storage, including Cookies, Local Storage, Web SQL, IndexedDB, cache, etc.

Of course Chrome also leaves pages out of the browser's history.

As a developer, it is also interesting to note that Incognito DOES NOT create a separate data partition for each window or tab.

All windows and tabs share access to the same cookies, so you can't create separate tabs to simultaneously log in as different users to one system that uses cookies to transmit authentication info.

Based on this, you still need to use a different browser to test this scenario.

Just an important privacy note on @Jared Dykstra answer and @Mark comment.

but everything starts "fresh" when the incognito window is launched. This applies all storage, including Cookies

Not 100% true

Today I opened a new fresh chrome incognito window and requested youtube.com . but I surprisingly found that youtube is recommending some videos to me!!! How? based on what ? I'm supposed to be a very new client with fresh browser - I noticed the recommended videos was based on the videos I usually watch while signed in to my google account from chrome or firefox -

After investing the cookies I was shocked that chrome is sending these cookies to youtube.com along with the very first request send to youtube.com from a new freshly opened incognito window.

GPS
PREF
VISITOR_INFO1_LIVE
YSC

I guess youtube.com servers used these cookies to know who I'm and recommend videos for me based on them.

I checked Firefox and it does not do that, it starts the private windows with 100% empty cookies header!