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I have been looking for the same thing i think it only works when 2 players of different levels play together as far as i see it the only way to play lower level zombies is to join a lower players game but i may be wrong with that setting
It's an option for multi player only, and the zombies will scale to whatever the hosts level is. So if you turn it off and join a level 2 players game, and you are a level 40, you will be fighting level 2's. If you are a level 2 and have it off and you join a level 50, you will be fighting level 50's.