First, the 8086 uses the "Group Decode ROM" to analyze the instruction. It determines if it uses a ModR/M byte, a word bit, ALU, and various other features. The mod and r/m fields are copied into the N and M registers, internal 8086 registers that are invisible to the programmer.
Now microcode takes over, running the internal steps for the instruction. Each micro-instruction is 21 bits long, with 5 different types of micro-instruction. Each moves an internal source register to a destination. It also does a particular task such as an ALU or memory op.