Yep, it's tricky, but the option is correct....It's only a question of what is the root folder for dir2dat...
Let's assume the following:
D:\temp\test is your dir2dat root, the source folder
In there you got 3 files, one on root level, another one in a folder names Set1 and the last one in a subfolder of Set1, called sub1
D:\temp\test\141.xml
D:\temp\test\Set1\141.xml
D:\temp\test\Set1\sub1\141u1.xml
Dir2Dat will then create:
<game name="default">
<description>default</description>
<rom name="141.xml" size="45487005" crc="a4debe29"/>
</game>
<game name="set1">
<description>set1</description>
<rom name="141.xml" size="45487005" crc="a4debe29"/>
<rom name="sub1\141u1.xml" size="46985053" crc="3c6f4755"/>
</game>
The first game for the one file since it can't find any useful set assignment for it, and the 2nd game takes everything from the folder set1 ...and *there* you got your subfolders