So far as I'm aware, if an alignment between 2 sequences is, for example, 200 bases long and the sequences have the same base at 70 positions, that's 35% identity. Nothing more complicated than that.
EDIT: more information
You need to look at the MUMmer source code (the src/ directory in the downloaded distribution).
You'll see files named sw_align.cc, sw_align.hh and sw_alignscore.hh in src/tigr. One would guess that the "SW" stands for "Smith-Waterman", a commonly-used alignment algorithm.
You can also use grep to search the source files for terms such as "percent" or "identity". For example, percent identity is defined in src/tigr/delta.hh as a float named idy.
And yes, I believe that indels are allowed, judging by the presence of functions to process them.
But this alignment uses edit distance, Hamming distance or some other scoring? E.g. do we allow indels or not?
But does this alignment use edit distance, Hamming distance or some other scoring? E.g. do we allow indels or not?
Edited my answer to provide more information.
Is the % IDY computed with respect to the longer length or the smaller length?