The best difficulty setting I have seen in a game is in Super Robot Wars.
Super Robot Wars is a strategy RPG (like Fire Emblem, Shining Force, Tactics Ogre, Disgaea, Final Fantasy Tactics, etc) where you progress the game in a series of static chapters (like Fire Emblem). Each chapter has a win condition and one or more loss conditions. Each chapter also has a (depending on the game, either secret or displayed, more often displayed than not) Battle Mastery condition that awards the player a Skill Point if they achieve it. It's an optional, harder objective that replaces or supplements the victory condition, like a time limit, reducing an unkillable boss's HP to 0, killing all enemies instead of targeting only required ones, killing only CERTAIN enemies, keeping specific targets alive, doing a completely different victory condition altogether like hitting waypoints or escaping the map, and so on. The more Skill Points you have, you'll go on harder missions later in the game, culminating in there being an additional final stage with a larger, meaner end boss immediately
after killing the original end boss. The fewer Skill Points you have, you'll go on easier missions later in the game, and you miss out on secret items and units. There is additional story sometimes, but the additions are per Skill Point (doing a mission under a time limit results in a completely different aftermath where your characters might defuse a bomb that otherwise would have gone off, for example) instead of large scale.
This gates the harder difficulties by player skill instead of requiring players to know how actually good they are or making them beat the game first. The Skill Points themselves often increase the game's difficulty already without doing stupid shit like inflating HP/damage numbers and making heals worthless, and many bosses use Skill Points as variables to determine their own stats and abilities. It's a really good system.
edit: Here's an example.
This is a flowchart listing all the Battle Masteries for every stage in SRW Z2.1.
This is a screenshot Let's Play of Stage 20 of that game. The basic victory conditions of the map are "Destroy all opponents" and the loss condition changes a couple times (GOD I love SRW) depending on which characters are important to the immediate plot. The Battle Mastery requires the player to defeat all enemies within 3 turns of the first of 2 gigantic waves of reinforcements, a feat which requires planning, smart movement, and managing a shitload of ammo so you don't blow it all taking out half the bosses early before the other half show up.