there are heaps of posts here explaining how it works
it uses your HD serial, username and password string. Do you know any programming language? did you want to convert it to another programming language or did you just want to know how it works?
If you go to microsoft and get VB 2008 Express, you can get the project I posted on Paltalk password decyptor [Delphi] and see how it can be done in VB… VB 6 will be slightly different, but the idea is the same.
Thanks to Nice Fox for providing us with the method of decrypting the Pal Passwords.