You still gain levels with XP, but if you haven't earned enough XP by the story point, then you gain enough XP to reach that level. This means that you can gain levels earlier than expected. If they spend more time investigating side quests, they earn extra XP and might gain a level before the story point, making the key encounters a little easier. If the party is smart and avoids unneeded encounters, they don't fall behind due to a lack of XP.
To give an example, the party started at level 3 in T1 - the Village of Hommlet. They cleared the Moathouse, gaining level 4. They then traveled to Nulb and the Temple Grounds, where they found a hidden entrance to dungeon level 3, where they unexpectedly recovered the Orb of Golden Death, which was the goal to gain level 5. They gained level 5 after only 2 sessions at level 4, earning nowhere near the XP needed. Later, in the Elemental Node of Air, they finagled a three way battle between themselves (at level 6), a pair of Adult White Dragons, and 5 evil Cloud Giants. After defeating all their enemies, they had more than enough XP for level 7, which they were not supposed to get until after they recovered the elemental gems. They gave them an edge in the nodes, with access to 4th level spells they were not expected to have. They did not gain a level upon recovering the elemental gems, however. The party was rewarded for smart play that lead them to the orb without having to work their way through the lesser temples, but also was rewarded for defeating powerful monsters, even though it was unnecessary (they didn't know this at the time).
