The file needs to be a .php file, and you can put it anywhere. You usually place it where the content from the included file would go.
The separate document is just a normal file.
Say I had an about me page and wanted to include a header & footer.
index.php
Code:
<?php include 'header.html'; ?>
Hi! My name is Dan. I'm a programmer.
<?php include 'footer.html'; ?>
header.html
footer.html
When you're done, the resulting page will look like:
Code:
<html>
<body>
Hi! My name is Dan! I'm a programmer.
</body>
</html>
Does that make sense?