From Diablo Wiki
Diablo III has four difficulty levels: Normal, Nightmare, Hell, and Inferno. As in the previous games in the series, each difficulty level repeats the same content (with a few minor changes), while scaling up all the skills, items, monsters, experience rewards, gold drops, and everything else to maintain a challenge appropriate to the character level.
The fourth difficulty level, Inferno, is a new feature in Diablo III, adding a much more challenging end game experience to the Hell difficulty that was the upper limit in Diablo II. While Inferno was a popular feature when first announced, the actual implementation of it has proven controversial and spawned numerous changes and tweaks in the weeks and months after Diablo III's release.
- 1 Difficulty Progression
- 2 Gem Drops
- 3 =Boss Modifiers
- 4 Life Steal
- 5 Monster Difficulty
- 6 Inferno Issues
- 7 End Game Difficulty Development
- 8 Level of Difficulty
- 9 BlizzCon Demo Difficulty
While most difficulty increases occur gradually, such as monsters steadily increasing their hit points and damage output, there are some preset changes between the difficulty levels.
The material an item salvages into depends on the item's level, not the difficulty level it's dropped on. There is a high correlation between higher level monsters and higher level items, but it is not absolute, and even in Act Four of Inferno the monsters will regularly drop items that are below level 60, and will thus salvage into Hell materials.
- Page of Training and Page of Jewelcrafting drop in Nightmare. These are required for gem upgrades and blacksmithing recipes of approximately Nightmare level.
- Items from level 30-49 will craft into Shimmering Essence or Lizard Eye.
- Tome of Training and Tome of Jewelcrafting drop in Hell. These are required for gem upgrades and blacksmithing recipes of approximately Hell level.
- Items from level 50-60 will craft into Wishful Essence or Encrusted Hoof.
- Level 60 jewelry and Follower-special items will craft into Inferno level materials.
- Monsters and objects in Inferno may drop Tome of Secret.
- Items at level 61 and higher will craft into Exquisite Essence or Iridescent Tear.
- Level 60 jewelry and Follower-special items will salvage into Inferno level materials.
- Legendary items of level 60 or higher will salvage into Fiery Brimstone.
Gems are not strictly segregated by difficulty level, the way the tomes and books of training are. Gems are first seen dropping in mid-Act 2 of normal difficulty, when chipped gems begin to show up. The quality of gems progresses steadily as players advance through the difficulty levels, with a rough correspondence to the pages and books of jewelcrafting that are required to upgrade them. By Inferno only Square and Flawless Square gems drop. Flawless Squares are the highest quality of gem that ever drops, and higher qualities must be crafted with the Jeweler.
One annoyance that's persisted until at least patch v1.0.5 is that Square quality gems require a Tome of Jewelcrafting to upgrade, and while square quality gems drop constantly in Inferno, Tomes of Jewelcrafting do not drop past Hell. Thus players in Inferno must return to Hell and farm for tomes to upgrade their gems. (Though it's much easier and quicker to simply buy stacks of the Tomes in the Auction House.)
Boss modifiers are introduced gradually as a character progresses through the game. The bosses found in the earliest portions of Act One can only spawn with one of three Modifiers: Nightmarish, Knockback, or Teleporter. This process evolved during the beta test, as nasty boss modifiers such as Arcane Enchanted, Molten, Jailer, and Frozen were gradually removed/moved to higher monster levels. These are now found later in Act One, and by Act Two all the possible Normal difficulty boss modifiers may be encountered.
Normal Difficulty modifiers. Bosses and Champions will have only one of the following:
- Desecrator, Electrified, Fire Chains, Frozen, Illusionist, Jailer, Knockback, Molten, Mortar, Nightmarish, Plagued, Reflects Damage, Shielding, Teleporter, Vortex, Waller.
Nightmare difficulty adds additional modifiers to the selection pool, and all random bosses and champion packs will have two modifiers semi-randomly selected from the pool of all previous modifiers, plus these new ones:
Hell difficulty adds additional modifiers to the selection pool, and all random bosses and champion packs will have three modifiers semi-randomly selected from the total pool:
- Avenger and Health Link.
- (Invulnerable Minions was initially enabled in Hell, but was removed from the game in v1.0.4.)
Inferno does not add any additional Boss Modifiers, but all Bosses and Champions spawn with 4 modifiers, which can create combinations not seen previously.
All boss modifiers are sorted into three classes, which limits their combinations in various ways. For instance, only one of the four Class One modifiers can spawn on a given enemy. These include Knockback, Jailer, Nightmarish, and Vortex. Thus no monster can ever have two of these modifiers. See the Modifier Grouping info on the Boss Modifiers page for full details.
The effectiveness of the Life Steal affix – which restores your Life by a percentage of the damage you deal – is reduced on higher difficulty levels:
- Normal: 100%
- Nightmare: 70%
- Hell: 40%
- Inferno: 20%
Numerous monster properties vary by difficulty level, with enemies growing more resistant to stuns and other CC effects on higher difficulties.
Tweaks to these formula are frequently enabled. In September 2012, Wyatt Cheng posted an extensive developer blog post with details about changes in the v1.0.5 patch. 
- Monsters have a “CC resistance” that is stored on a per-monster basis.
- The CC resistance starts at 0%. For every 1 second CC that is applied to the monster, the monster receives 10% CC resistance.
- Monsters lose 10% of their CC resistance every second that they are not CC’d.
- Elite monster CC resistance is capped at the current reduction values already active for Elites. In other words, CC resistance on most Elite monsters is capped to:
- 35% in Normal
- 50% in Nightmare
- 65% in Hell
- 65% in Inferno
What This Means For the Player:
- From a high level, diminishing returns are applied on consecutive stuns to reduce their effectiveness.
- You will never get an “Immune” message due to diminishing returns.
- Diminishing returns on Elite monsters cap out at the same values that are currently applied to Elite reductions.
- As previous mentioned, this means that near-infinite CC strategies will still work. We’re okay with these strategies remaining viable, as we love how powerful it makes players feel. (That said, we will continue to keep an eye on these strategies and may make some changes in the future if we feel it will be better for the health of the game.)
- If two players are in a co-op game, the order in which they apply their stuns doesn’t generally matter, so you shouldn’t feel totally “screwed over” by the other person applying their stun before yours.
- A character using only the occasional CC every 10-15 seconds will always get the full duration in all difficulty levels.
While initially planned as a "flat" difficulty level, where the monsters in Act One would have been approximately as challenging and rewarding as those in Act Four, the D3 Team modified Inferno during development and ultimately made it scale up in challenge.
Since most characters will reach the max level of 60 while still in Hell, all character progression in Inferno is based on improved items, and this has led to much complaint and debate about the difficulty of Inferno, as it seems a hard "gear check" to many players. This feeling of being unable to progress further without better equipment, and of the extreme difficulty of finding such equipment in Diablo III's random item generation system, fueled much controversy and a number of game tweaks in the weeks after Diablo III's release.
Patches v1.0.3 and v1.0.4 includes numerous nerfs to monster difficulty and improvements to monster drop rates in Inferno. The balancing process is ongoing.
End Game Difficulty Development
Jay Wilson: The combat model doesn't have a lot of depth in the previous games. It was very much a "one-skill spam" kind of game, which I think works great for the Normal [difficulty] playthrough. I think most of the audience is just fine with that, and through most of the Normal difficulty, it's going to be like that. But as you go into Nightmare and Hell difficulties, I think that the more serious player will appreciate a game that's a little deeper on the combat-mechanic side.
Kevin Martens: Ultimately, it’s going to take the game's harder difficulty modes -- Hell and Inferno -- to challenge the limits of the best Diablo III players.
There are four difficulty levels in Diablo 3. There are the standard Diablo difficulties called Normal, Nightmare, Hell, and Blizzard also announced a fourth difficulty level in August 2011 called Inferno. How much more difficult and what sort of variety the higher difficulty levels will add remains to be determined. Jay Wilson addressed this issue in a November 2009 interview. 
- What are the differences in the difficulty levels in Diablo III other than just monsters doing more damage? ie: What reason will people have to play through these modes after having already beaten the main story of the game on an easier difficulty setting?
Jay Wilson: We haven't really gotten into the difficulty settings a lot; we're still just working on the core content for the game at this point. The primary reason as to why a player would want to progress through the game, through the several difficulties, would be for more of a challenge.
There will be also better item customization, for example a Level 100 character in a higher difficulty would see and wear items that a Level 30 character would not have a chance at seeing in the lower difficulty. Said items will also look and feel completely different whereas in Diablo II a lot of times you just had a remodel of the same old items with different names.
Inferno was originally designed under the premise that the entire difficulty level would be scaled to an mlvl of 61. The design team felt that didn't play very well, so they later made Inferno ramp up in mlvl like all of the other difficulties, with most of the bosses in Act III and Act IV inferno sporting an mlvl of 63, three levels ahead of the player.
Unlocking Difficulty Levels
Much like in Diablo II, difficulties are unlocked by beating the previous difficulty. So to unlock nightmare, the player must have completed the quest The Prime Evil in normal. The same goes for Hell and Inferno.
However, there is a level restriction on difficulty levels. For Nightmare, the player must be level 25. For Hell, the player must be 50. Level 60 is the minimum entrance for inferno. If a player defeats a difficulty but is still behind the level requirement, the game will automatically place them at the beginning of the game in their current difficulty after defeating the final boss in Act IV. So if a player beats Hell mode, for instance, they will be brought back to the character screen at The Fallen Star, still in Hell difficulty.
When the appropriate level is reached, the game will inform the player once they level up via a special splash screen, seen in this screenshot:
Difficulty Scaling in Multiplayer
@Diablo did confirm, in November 2010, that difficulty was probably going to be based on the number of players in the game, not their Clvl. 
This remained true upon release of the game. The health of monsters scales with each player who enters the game, and when Diablo III shipped, monster damage did as well, which was subsequently removed in a patch.
Level of Difficulty
The D3 team promised that players would die in higher difficulties, and for the most part, they did. However, with Inferno difficulty at least, it isn't so much of an issue of a gear-check as it is with Diablo II-style monsters one-shotting players with cheap skills and boss modifier combinations. Upon launch of the game, players found ways to play cheaply in a cheap difficulty, but imbalances between classes and skills, glaring imbalances that were simply exploitation, were almost immediately hotfixed.
The D3 Team is still working on tuning Inferno and Hell difficulties to be more playable and balanced, and thus enjoyable, but only patches will tell.
We do know that many of the basic game changes in D3 have large effects on the difficulty of the game. The highest level potions are a stop-gap emergency measure, life leech is less effective (compared to Diablo II), and most healing comes from health globes or skills. On the other hand, monsters aren't full of immunities and blessed with cheesy one-hit kills (outside of Inferno difficulty). The D3 team has discussed this issue several times, and always pointed out that the abundant potions and life leech made D2 characters essentially immortal. Death came only from cheesy super damaging kills, most of which were bugs, and that's no way to balance a game.
In D3 they wanted a much steadier progression of difficulty, so that monsters can be challenging, without being buggy insta-death dealers. The D3 Team has also talked about the difficulty ramping up smoothly. They want normal to be fairly easy, so new players can have success and find their way into the game. The D3 Team doesn't want D3 to be a total cakewalk, since that gets boring too, but they're not looking to turn normal into a tooth and nail struggle to survive, which it isn't, but upon release was considerably more difficult than the content found in the beta test.
BlizzCon Demo Difficulty
Players who had tested out the game at demos in 2008, 2009, and 2010, have given varying reports of the difficulty. It's hard to judge across the board, since a lot of the people playing are were not experienced with the Diablo games, and were struggling with the controls, don't know how to use skills, were playing a new class for the first time, or were just rushing around madly during their short demo play time, rather than clearing out levels systematically.
More experienced players found the game pretty easy, especially when playing solo. The multiplayer is a lot more challenging, but much of that came from people going their own way in large games where the monsters are scaled up in difficulty, or from being partied with noobs who don't know what they're doing.
Also note that the demos were modified from the normal game. The characters were turned up a bit to make them stronger (so noobs won't die repeatedly and get frustrated), and the drop rate for items was increased, so players found more fun loot.
The D3 Team has acknowledged that the early stages of Diablo III will be fairly simple, but they claim that the difficulty will ramp up over time and become quite challenging on Nightmare and Hell, especially in multiplayer games.