When you have Face ID enabled and Face ID detects a face mask, and the iPhone is specifically enabled for the unlock-with-Watch setting, then the iPhone checks for a Watch in proximity that is both paired with the iPhone, and is passcode-unlocked for use, and if that paired and unlocked Watch is detected in proximity, then the iPhone unlocks for most uses, and a haptic notification and a “cancel iPhone unlock” message dialog is shown on the paired Watch.
The unlock-with-Watch setting is not the default setting for iPhone, and enabling unlock-with-Watch displays a dialog box with related info to confirm understanding of the security trade-offs when the setting is enabled.
I had a few issues with this feature not connecting and not working when first available, though those were resolved with the latest updates to iOS (14.6) and watchOS (7.5) and the feature now works.