Funny thing that you mention it now as I got it working myself like 2 or 3 weeks ago (as seen here : )
You can set max 8 sprites with priorities. I don't want to add confusion, but your command will reference a sprite "type" from 0 to 7 (I'm not talking you the bits info here, really what you see in the manuals as "priority"), and you can decide to give them different priority (usualy you only need 2, so say Sprite "type" 0 at priority 5, and Sprite "type" 1 at priority 4. (the sprite type here just references a priority setting, so you could always use Sprite 0 for everything and all your sprites will have priority 5).
The color code includes the MSB, the sprite priority, the VDP2 color calculation ratio (one out of 8 registered ratio values), the color bank offset and the color ID.
So, depending on your sprite type, you will have different values.
But say you have a 8 bpp sprite, you need 3 bits for the color bank (one of the 8 possible 256 color banks in your 2048 colors RAM) and 8 bits for the pixel color ID.
That's what will be transfered to the VDP2, which will then apply the color calculation while writting to the framebuffer.
The sprite priority, at least from my personnal experience, is mainly (if not only?) for color calculation/shadow using the VDP2 as using different priorities won't impact which sprite pixel gets written over which sprite pixel (the ordering of commands sent to VDP1 will determine those), only what priority the sprite has over the other VDP2 layers.
Say I put my color calculation ratio condition at (priority <= priority 4), then I want to use some sprites without the effect, I will give them priority 5.
But for those sprites that I want to use the effect on, I will give them priority 4 or less and specify the ratio (0 to 7).
16 CLUT sprites can be used both as RGB and color bank sprites, but I couldn't change the color calculation ratio since it needed more bits for the LUT address and setting the priority didn't seem to work when I tried. But you can set your color calc condition at MSB and set the color MSB to 1.
Note that for CLUT sprites you need to set the 16 RGB values' MSB to 0 so that they get treated as VDP2 CRAM sprites.
Another usage with priority that you could also, I guess, "hide" a sprite behind a layer or a VDP2 window (could be nice to mix both to have full transparency over sprites using the VDP2, using the NBG0 or NBG1 as some kind of framebuffer like in Burning Rangers with some software rendering).
Some of this info could be wrong since I'm using SGL and only use a couple of manual draw commands, but overall it should help you I hope.