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I have a character who gained an item that gives him DR 5\bludgeoning.

I am assuming this only effects bludgeoning weapons such as hammers. If that is the case does it effect AC adding 5 to defense when being attacked or does it reduce damage dealt by 5? (I believe it is the latter but want to be sure.)

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Actually, in the Damage Reduction notation, the text after the slash tells you what ignores the damage reduction. So DR 5/bludgeoning subtracts 5 from weapon damage unless the weapon is a bludgeoning weapon (like a hammer, yes; all weapons will indicate their damage type).

Note that some weapons might be “bludgeoning and piercing” – these ignore DR x/bludgeoning as well as DR x/piercing, and would also ignore DR x/bludgeoning-and-piercing which neither bludgeoning-only nor piercing-only weapons would.

It’s also common to see things like DR x/magic-and-bludgeoning, which means only magic bludgeoning weapons can bypass it. Less common would be something like DR x/magic-or-bludgeoning, where any bludgeoning weapon (even if not magic) or any magic weapon (even if not bludgeoning) would bypass it.

Finally, DR x/– simply means that no physical damage type bypasses it at all.

If multiple DRs apply, e.g. you have DR 5/bludgeoning and DR 10/magic, and you’re attacked with a non-magic, non-bludgeoning weapon, only the highest applies (so you subtract 10, not 15).

Also, Damage Reduction only applies to “physical” damage, not energy damage like cold or fire. So a fireball does full damage despite DR 5/bludgeoning. Energy Resistance works like Damage Reduction (sort of) for energy damage.

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"Note that some weapons might be “bludgeoning and piercing” – these ignore DR x/bludgeoning as well as DR x/piercing, and would also ignore DR x/bludgeoning-and-piercing which neither bludgeoning nor piercing weapons would." does this mean that the weapon can be either bludgeoning or piercing to bypass? I am just confused with the wording. –  Vethor Aug 12 '13 at 21:59
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@Vethor DR/bludgeoning-and-piercing requires a "bludgeoning and piercing" weapon (like morning star) to bypass. DR/bludgeoning-or-piercing is bypassed by bludgeoning weapons, piercing weapons, and bludgeoning-and-piercing weapons. –  KRyan Aug 12 '13 at 22:02
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One thing that should probably be added to this excellent answer: Damage reduction only works against weapon damage and natural attacks. It doesn't apply to damage inflicted by great balls of fire, falling great heights, or running a marathon. –  GMJoe Aug 13 '13 at 6:23
    
@GMJoe Fair enough. I had thought "weapon damage" indicated that, but then I suppose it doesn't apply to all weapon damage (such as the fire damage from a flaming weapon). –  KRyan Aug 13 '13 at 12:59
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@acolyte DR/+# is 3.0, not 3.5. That's been replaced by DR/magic. DR/epic isn't really special or different from other DRs: epic weapons bypass it. –  KRyan Aug 13 '13 at 17:58
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It is the latter, bludgeons negating the DR.

d20srd.org states:

A creature with this special quality ignores damage from most weapons and natural attacks. Wounds heal immediately, or the weapon bounces off harmlessly (in either case, the opponent knows the attack was ineffective). The creature takes normal damage from energy attacks (even nonmagical ones), spells, spell-like abilities, and supernatural abilities. A certain kind of weapon can sometimes damage the creature normally, as noted below.

The entry indicates the amount of damage ignored (usually 5 to 15 points) and the type of weapon that negates the ability.

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+1 for "The creature takes normal damage from energy attacks". Always painful to learn this with a fireball coming at you. –  Trajan Aug 12 '13 at 14:48
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