LZW is a lossless data compression algorithm that replaces repeated strings of characters with codes. It works by starting with a dictionary of single characters and building the dictionary as more data is encoded. Strings are replaced with codes which are output, and new strings are added to the dictionary. For decompression, the same dictionary is rebuilt from the codes to reconstruct the original data losslessly. LZW is particularly effective for text compression and was used widely in GIF images due to its good compression ratio and efficiency.