Does anyone know what this playing by ear really is?

I do it. It's a biofeedback thing, where you look at the pattern of keys on the piano (for example) and start sounding things out. Your eye sees the keys, your ears hear the sound, and when you've played the tune, your brain says "That's right." It's similar to how the new kids in a school band learn to time by looking at their music while hearing the older kids play it right.

It's also similar to how children learn to read in school. We look - hear; look - hear; and pretty soon we're doing it.

The more you do it, the better you get. I find it is far easier to sound out something that goes up and down the scale than to do it with a song with a lot of big hops.

However, it's also good to learn to read music. There are always songs which prove hard to sound out, and someday a strange and unexpected chord calls to us. Then it's good to read the music and see what to play.

Is it an inherited ability? Probably. But I think doing it regularly is more important.