I've always assumed it was by time. That is, a setting of 1 is 0.5 secs, a setting of 7 is 3.5 secs. When I drive behind another vehicle, and it passes a line on the road, I count the time before I pass, and when I'm on 7, it's just over 3 secs.
Using time as the distance parameter, allows for different distances based upon speed, and of course, stopping distance is also varies upon speed, so time seemed to me to be the obvious variable.