Yes they work the same as folders. The smart bit is that while a physical file in a filing cabinet can only sit in one folder, an email can have any number of labels. So it's quite possible to use labels as folders but to take advantage of the extra possibilities that labels add, Google reckoned it was worth the slight initial confusion.
Once you add in a few filtering rules you can get your email well sorted.
Another thing worth mentioning that can help filtering email is that Google allows you to add a plus sign + and another word after the first part of the address. This is ignored for delivery but is handy for organising afterwards.
So an address of say,
tom@smith.com can be
tom+phonebill@.smith.com.
Handy for knowing who passed on your address to junk mail senders.