The maximum party size is 6 players.
You can create a party by either selecting a player's name in chat, clicking on them in town, or typing /invite Playername in the chat. In addition, you can create or join public parties by clicking on the Notice Board in town, or by pressing S and looking in the Public Party tab.
Effect on monsters
Monsters gain 50% extra life for each additional party member after the first. For example, against a party of 3 players, monsters have double life. The original life amount is used for the purposes of determining the length of Stuns and Status Ailments from Elemental Damage - this means monsters will not be harder to stun/freeze/etc. when fighting in a party.
Effect on loot
Each additional player gives the equivalent of +50% item quantity modifier on drops. So a party of three will see twice as many drops as a lone character. Increased Item Rarity & Quantity modifiers are only counted from the player who lands the killing blow. This sort of item quantity doesn't increase chance of getting more Map drops. Only the item quantity bonus that a Map has (due to its Mods) will affect the drop rate of Map items within that Map.
Effect on experience
Experience is split between all members in the party. The amount you get depends on your level relative to party members and monsters.
Level affects the amount of experience you gain from killing enemies. There are two penalties that are applied, one when in a party, and another based on the relative level of the player and monsters. Both of these are applied at the same time if you are both in a party, and too far above or below the monster level.
The multiplier for experience while in a party is players share (Level+10)^2.71 divided by the total of all players shares. For example, if a level 10 player was partied with a level 30 player:
Level 10 player's share: (10+10)^2.71 = 3355
Level 30 player's share: (30+10)^2.71 = 21957
Total Shares: 3356 + 21957 = 25313
Level 10 player would receive: 3355/25313 = 0.132 = 13.2% of the XP
Level 30 player would receive: 21957/25313 = 0.867 = 86.7% of the XP
The player also suffers a penalty to XP if they are too far above or below the monster's level. There is a safe level range where no penalty is applied, which is equal to three, plus one for every sixteen complete player levels. Any additional level difference in excess of this safe range is called the Effective Difference.
The formula then applied is:
((PlayerLevel +5)^1.5) / ((PlayerLevel+5+(EffectiveDifference^2.5))^1.5)
So a level 24 character has a safe band of 3+1=4 levels. So from Monster level 20 to 28, there is an effective level difference of 0. At Monster Levels 19 and 29, the Effective level difference is 1. The Effective Difference matters in either direction.
Only party members actually in the instance count toward getting XP. If one member is in town he gets no XP.
Experience is only shared with other players who are near you (roughly two screens). Monsters are still made harder by players elsewhere on the level. Being in an area with a party member grants you a 30% experience bonus. As of 0.9.13e, monsters no longer give +50% base XP for every party member after the first - therefore, players to need to nearby in order to benefit from being in a party.
Effect on flasks
Flasks have a +75% charge recovery bonus for each party member after the first.