Blood bags are used to restore another player's health to full by giving them a transfusion. They are most commonly found in hospitals; usually inside of medical boxes, but can also be found in medical military tents and in medical boxes that may or may not spawn by a crashed helicopter.
Blood bags cannot be self-administered; they can only be used on other players. Transfusions are given to another player by choosing the "Give Blood Transfusion" option on their mouse wheel menu. This option will only be available when looking at a player with less than 12,000 blood and only if the blood bag is in your active inventory and not your backpack. As of 184.108.40.206, when giving a transfusion to a player, 1,000 blood is transferred every second of the process instead of it being instantaneous as it was in previous updates. If the player receiving the blood moves during the process, the transfusion will stop and leave said player with what blood he was transferred before he/she moved.
When a blood transfusion is given to another player, the player who performed the transfusion will have their humanity raised by 250. This means they are frequently used by bandits to raise their humanity in order to obtain the survivor skin, or the hero skin. While this can take time, this unfortunately means that heroes and survivors may easily be bandits in "disguise".