Arbitration is a form of alternative dispute resolution. Alternative means outside of court.
There are two primary methods of alternative dispute resolution: arbitration and mediation. It is instructive to understand the differences between the two.
Arbitration is result oriented.
The salient feature of arbitration is that the two parties submit their resolution proposals and a third party (the arbitrator) picks the one s/he considers most fair. This gives both parties incentive to submit fair proposals. If the rules were, say, to split the difference, the parties would have the opposite incentive. To take the most extreme position in order to influence the outcome more toward their side. So the rules of arbitration are designed to facilitate fair (or middleground) proposals by the parties.
Mediation is process oriented.
By contrast, mediation is a method by which the parties engage with a third party (the mediator) who acts as an interlocutor to help the parties negotiate a settlement. Often times, it is helpful for the mediator to also serve as an arbitrator in the event the parties can not reach an agreement. The threat of arbitration gives the parties incentive to act in good faith.
Alternative dispute resolution is a common and cost-efficient relative to judicial proceedings. Each method has its unique set of advantages and disadvantages. Each can be used alone but they are often most effective when used together — mediation followed by arbitration if mediation fails.