The Do Not Track policy exists to prevent social networks, analytics, and online advertising from following you around the internet and recording your browsing patterns. Browsers that respect Do Not Track - like Apple's Safari - and websites that respect it, will allow you to surf the web in peace and privacy. Cookies - the way many sites and networks identify and track you - can likewise be blocked in several ways, including just those used by advertisers and third parties, and completely.
Blocking "Third parties and advertisers" is a good compromise. It won't prevent the website you're actually on from functioning the way it should, but it will prevent other websites from getting their hooks into your surfing.
That's all there is to it. iOS 7 Safari will now obey the settings you've selected regarding your privacy for each time you browse going forward.