I did a quick test. Made sure "do not disturb" wasn't on (on watch and on phone). Then, turned off "sync do not disturb". Then, turned on "mute notifications on phone when wearing watch". Then, had someone call my phone. When the call came in, the audio for the ringtone (and shortly afterwards for also the voicemail notification) played on both the watch and on the phone. They both played fully, clearly and without interruption/breaks (but I assume they shouldn't have played at all).
I noticed that the "mute notifications on phone when..." setting at the wear app says it's about allowed notifications on the watch. Maybe there is something else also in the notification setting for the phone app, in the wear app or on the watch. I didn't notice anything weird or obvious, didn't specifically look too much further into it either though, but did also notice for my arrangement that not all apps had been selected for "choose which apps are allowed to send notifications".
Also, on my phone wear app there is two possible sub settings associated to "show phone notifications on watch", about alerts if the phone is in use or if the phone isn't in use. I didn't play around with different combinations for also those.