Wounds can happen in a variety of different activities, from combat to logging to climbing. Injuries to vital areas, if severe enough, can cause death, while wounds to arms and legs can severely hinder your combat prowess in ways such as lowering associated skills or making you incapable of swinging a two-handed weapon. In terms of colors, yellow is least wounded while dark red is most wounded.
From least severe to most:
Player characters generally have a hundred points of health in all locations except for the eyes, which have fifty. Just as well, some large animals will take a lot more punishment to cause wounds and many smaller animals have less health. If any location on the head or torso is hit for equal damage to its max health or the accumulated damage exceeds it maximum health, the target dies immediately.
If a wound becomes bad or severe, many targets will begin bleeding. For most players, this means your energy no longer recovers and will steadily drain itself until the wound is bandaged or you die. Even if you don't have appropriate poultices, you can apply an untreated bandage to the location and if you succeed, you will stop the bleeding until the bandage comes off, meaning your energy will recover normally and you will not lose it over time, but nerfs from heavily injured legs and feet, for example, will still apply.
Scrapes and light wounds can be healed with bandages bought from infirmaries while bandaging a worse wound will only stop it from continually bleeding while the bandage lasts. To heal worse wounds, will require player made poultices, a trip to the infirmary, or a friendly Monk.