I'm against better loot at higher difficulty for the reasons given elsewhere - it has the paradoxical effect of making hard difficulties easier and also creates the impression (intentionally or not) that hard difficulty is the "correct" way to play.
As for the difficulty levels themselves, it's true that just ramping up enemy health and damage isn't a very good approach. It's apt to make the game more grindy rather than more challenging, and it's also a totally uninteresting way to do it. Changing enemy AI/tactics is a much better approach, and while I'm not sure how readily the game could handle it, changing the tactical challenge is another option.
As a generic example: if the difficulty is set to easy, the archers in this encounter are standing in an exposed location. If it's normal, they're reasonably sheltered behind melee enemies. If it's hard, they're positioned on elevated areas to one side of the battle which makes getting to them even more difficult, and shooting at them from below is also more difficult unless you have a good angle on them.
Replacing one creature type with another of similar power but with different capabilities can also work to this end if it affects the synergies between creatures or even just increases the number of things that the player has to take into consideration while fighting them.
