Growing evidence indicates that games allow students to focus well enough to learn better. The Oct. 2010 issue of Training + Development magazine (American Society of Trainers and Developers) cites results of a University of Colorado study showing that using games to train adults in the workplace resulted in higher factual and skill-based knowledge levels and higher retention levels than programs that did not incorporate games.
Not surprisingly, the Internet has had a significant effect on the way 21st-century college students think and learn; they are used to thinking on multiple tracks at once, but have little patience with linear reasoning or delayed gratification. Using games (not necessarily video games) for teaching is one way to shift to a more appropriate learning format for the digital generation. If learning is more engaging, students will be more motivated. In addition, competition and teamwork are motivating for students, and quick and specific feedback enables students to figure out the right way to succeed.
Games work as a teaching tool because bad consequences are rarely serious or lasting. Often, it's possible for students to recover within a game, and use what they have learned to successfully complete a task. Because games are not graded, they allow students to assess their knowledge for themselves and give them a chance to see where they are having trouble before they engage in graded activities like papers or tests.
Game-based learning also teaches students to follow directions, make decisions and discover new information. Peer learning involved in game instruction allows discussion, reflection and problem solving. Game-based instruction also encourages teachers to be creative and more effective and helps them identify difficult or poorly understood material through observable, immediate feedback from the students.
You can find some good sources on game-based learning at the Carleton College Science Education Resource Center.