What is indexation and what are its benefits?

Indexation is a process by which you can index (adjust or inflate) the cost of buying an asset over a period of time in order to bring it to current prices after taking inflation into consideration. A Cost of Inflation Index (CII) is used for indexing or adjusting the price of the purchased units after inflation.

To understand the adjusted cost of the allocated units, we divide the Cost Inflation Index of the year in which the units are sold by the Cost Inflation Index of the Year in which these units were allocated and then multiply the figure by the actual cost at which the units were purchased. This will give the price of the allocated units which can be used for calculating the Long Term Capital Gains. 

For Example – Mr. Ram purchased 5000 units of Hybrid mutual fund XYZ at ₹ 16 in the Financial Year 2012-13 and then sold these at ₹ 26 in the Financial Year 2018-19. (As the units were held for more than 36 months, this transaction qualifies for indexation benefit)

The profit earned is: 5000 (26-16) = ₹ 50000
First, we arrive at the Inflation adjusted purchase price:
Inflation-adjusted purchase price: ( 280 /200)*16 =22.4 

Long term capital gains for the transaction is,
The profit earned x {(Price of the units in the year 2018-19) - (Inflation-adjusted purchase price)}
5000 x (₹ 26- ₹ 22.4) = ₹ 18000
(Here Cost Inflation Index number for 2018-19 is 280 and that for 2012-13 is 200. The numbers have been taken from the Income Tax Site)

Note: This Cost of Inflation Index number is notified by the Finance Ministry for every Financial Year and is available on the Income Tax Website

Related question(s):
Do I have to pay taxes on profit earned from mutual fund investments?
What if my annual income is less than the threshold amount below which income is exempt from tax?
Will there be any TDS on profits earned when I sell my mutual fund investments?