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It doesn't.
The limit is set by the people hosting your specific instance, as they're the ones who then have to host that image.
Different instances have different limits.
You can use other image hosts, tho, as long as they give you a direct image link. Just plop it into the url field/use it in a markdown image, instead of uploading to lemmy.
Your admins define the size limit.
It's instance dependent.
.ml is running the beta branch that actually started to apply image size limits to thumbnails, your app is probably using the thumbnail URL instead of the main URL and thus getting the compressed image.
What kind of image is it? Reducing the number of colors in a PNG is usually inferior to JPEG compression. It can be OK for screenshots of texts and simple drawing but otherwise you're better off with lossy JPEG or WebP.
Some instance admins don't even use the built-in pict-rs server so media cannot be uploaded natively at all.
Some only allow month-old accounts to post images up to 500 kiB.
Others leave the limits on the relatively high defaults: 10 MiB per file and up to 900 frames for soundless animation/video, which must be in WebM format and VP9 codec (or it will need to be reencoded, which usually fails because of the short timeout). It's easy to use ffmpeg or HandBrake to create low-bitrate 30-second HD videos that fit but the limits are not visible to users and even the defaults are nowhere to be found in Lemmy documentation, I had to read the source code.