It means "very stupid" but in a more hilarious, weird, and/or spontaneous way. From the Latin word for "slow".
If you want to tick off a politically correct person, just say it. They think it's mean because people with mental problems are not always stupid, except you can't call those people "retarded" in the first place, and nobody cares anyway. Plus, once again, it's from the Latin word for "slow".
*Guy 1 is dancing very strangely.*
Guy 2 to Guy 3: Look at Guy 1 dancing like he's retarded.