I know next to nothing about Knoppix actually, but seeing as nobody else has tried answering this, I'll give it my guess.
I would guess that Knoppix uses the ramdrive for its base running filesystem, including all the major files it needs to run as well as whatever files and programs you create during that session. So it probably holds a large part of the root filesystem, at the very least. The kernel is probably held in regular memory, however, like in most systems. The ramdrive probably uses the standard ramfs filesystem as its base.
The ramdrive is then merged with the cd filesystem using unionfs, which makes the two separate drives look as if they were one contiguous file system. The ramdrive part holds the files that can be changed, while the unchangable stuff remains on the cd. The result is a file system that can be mostly held outside of memory, but can still be altered when necessary. If you load everything into memory with toram, however, then the ramdrive will also hold everything that's normally accessed from cd, freeing the drive for other uses.
Remember, this is just my semi-educated guess here. I wouldn't be surprised if I was completely wrong. But I think that's the general idea.