Manchester encoding is a technique used in the physical layer of the OSI model to encode data for transmission. It works by assigning transitions from 0 to 1 or 1 to 0 in the center of each bit to represent the bit value. This allows the receiver to easily extract the clock signal and correctly decode each bit. While it provides improved clocking and reliability over other encoding schemes, Manchester encoding exhibits poorer bit storage density for storing data on magnetic media.