Turning this option on here does not force authentication. It simply tells Dansguardian to look for the usernames if they are already being used by the squid proxy server.
"Digest Authentication" requires that you turn OFF IPCop's transparent proxy setting, your web browsers (Internet Explorer, Firefox, etc.) all must be configured to use a proxy server at IPCop's IP number, port 8080. You also need to install the Advanced Proxy IPCop addon, and configure squid to require Digest Authentication.
The Digest Authentication method encrypts the passwords, making it very hard to steal them unless weak passwords are used.