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I know what a VPN is, and I've done a little reading about how to set up VPN on demand. However, I'm confused.

Is VPN on demand essentially a certificate instead of a password prompt on each connect? Do apps need to take care of this specifically, or does iOS handle it whenever it sees that an app wants VPN on demand? What is VPN on demand?

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Yes, it does involve authentication by certificate. From this article from Apple:

iOS supports VPN On Demand for networks that use certificated-based authentication. You specify which domains require a VPN connection by using a configuration profile.

The VPN connection is made whenever the device tries to connect to certain domains. Specific apps don't need to do anything; as soon as they try to access such a server the VPN connection is initiated.

Visit this support page for information about how to use the Configuration Utility to create a configuration profile that sets up VPN On Demand.

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    In general, though, this feature need not be tied to certificate-based authentication schemes. Your company might serve crazycoolcats.corp and it may be really important that employees using iOS devices be able to reach that service. You can use on-demand vpn to configure iOS to use your local DNS servers when resolving *.corp domains. – dcow Sep 28 '15 at 22:07
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    FYI support page links is broken. – machineghost May 18 '17 at 18:13

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