Arbitration is something that was negotiated into the collective bargaining agreement in order to help players who were not eligible for free agency to be paid similarly to players who were eligible.
How it works:
Essentially, both the player and the team submit a single figure, and an independent arbitrator looks at both cases, and chooses one of the numbers. The arbitrator is not allowed to choose any number other than one of the two that were submitted.
Each case is based on similar players. Both the team and the player will build their cases around what they view as “comparable players”. Generally this will include service time, a player’s accomplishments, and other improvements/deficiencies that a player has.
Who is eligible:
Any player with at least 3 years of service time can qualify for arbitration. In addition, the top 17% of all 2nd year players (in terms of service time) will also qualify as “Super-2’s”.
Any free agent can be offered arbitration, but unlike players that are not free agents, can either accept or decline arbitration. If they accept, they are subject to the decision made, and are no longer free agents.
Another thing to remember with arbitration is that it is related to free agent compensation.
MLB Trade Rumors has put together another great post about this topic as well.