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They are used to restore the Staff Energy Meter, which allows Fox McCloud to use of various Staff Upgrades. Staff Caverns always have a plentiful supply of Gems, should the player ever run low on them.
The Gems come in four colors. Different colored Gems restore a different portion of the Staff Energy Meter. The Gems' restoration capabilities from worst to best go as follows: green, red, yellow and blue. This of course means that the green ones are also the most common.