I have multiple entities indexed. Hibernate search created multiple folders for each entity underneath the base directory. When searching for an index how does Hibernate search know which directory to search the index in? Or will it search in all the folders?

it depends on the type you're targeting for the Search.

The method:
http://docs.jboss.org/hibernate/search/4.3/api/org/hibernate/search/FullTextSession.html#createFullTextQuery(org.apache.lucene.search.Query, java.lang.Class...)

takes optional types. If you specify the type, it will be able to narrow down the set of indexes it needs to "look into".

A similar strategy happens when you specify filters, with some filters it can further narrow down the set of indexes or even the set of shards being uncluded in the search.
http://docs.jboss.org/hibernate/search/4.3/reference/en-US/html_single/#query-filter-shard

With such a custom filter you can also take control of the selection logic, in case you have additional hints.