Nobody really knows quite what it means to say that two animals are different species.
Despite many, many, many years of pondering the problem (about four hundred years formally, quite a bit longer informally), biologists have yet to actually come up with a working definition of what a "species" is. High school students in the Western world are taught that two animals are of a different species if they meet certain criteria, the most significant of which is an inability to produce viable, reproducing offspring. By this definition, a human and a horse aren't the same species because they couldn't naturally have a child together. Horses and donkeys can reproduce together, producing a mule, but because mules are sterile, this isn't a reproductively viable offspring, so they aren't the same species. So, we have a working definition of species which most people hold to be true, and which is perfectly serviceable... most of the time. It turns out, though, that a lot of different things can prevent two "species" from reproducing. One classic example, often taught in university but rarely in high school, is that of two species of bird which are nearly identical but have never reproduced together... because there's a mountain in the way. These birds were long ago divided into two species because the scientists observing them made some assumptions which, when genetic testing came along, proved to be a little premature. There are quite a lot of similar examples out there which show the problem of this definition of species, and here's my favourite: according to the definition above, it could be argued that two humans are different species from each other because they own a condom. Obviously, this is a spurious example -- take away the condom and reproduction becomes possible -- but the point stands that a lot of things can prevent reproduction aside from large-scale anatomic differences.
In medieval fantasy, this is a hugely complicated discussion. A human is physiologically tremendously different from an elf: they're built different, they have different temperamental predispositions, and of course, the elf has every chance of living more than ten times longer. None the less, in the popular SRDs, they're obviously able to reproduce, because there's the "half-elf" right there in the list of playable races. Of course, humans and elves are *pretty* similar, aside from the question of how they age, but what about orcs? In most fantasy games, orcs are tremendously different from humans in their anatomy and physiology, and yet, half-orcs. Are humans and elves, then, the same species? Are elves and orcs? If humans can have children with both elves and orcs, why don't the SRDs include elf-orc hybrids? The obvious answer -- that the rules were written by people who were more interested in story than in biological plausibility -- explains a lot, but doesn't actually answer any questions. Species clearly isn't quite the same thing as "race" in the SRDs, even though they do seem to use some of the same exclusion criteria. So, in medieval fantasy, what exactly is a species?
Heck, I haven't got a clue. I don't think we even really understand what distinguishes species in the real world, let alone fantasy worlds which aren't necessarily limited by logic. The point is, this much uncertainty and confusion leaves huge possibilities open to storytellers. There are countless story seeds that can grow out of some of these unanswered questions. The old Dark Sun campaign setting established that dwarves and humans can produce living children, known as mul, but the mul were all sterile, suggesting that dwarves are more different from humans than elves (and orcs!) are. This opens the doors to all sorts of other unanticipated differences between the species. Look further out, at the other races. Very few campaign settings incorporate the half-gnome. In Pathfinder, gnomes are descended from the fey, which might mean they have hugely different biologies from the other humanoid races despite the superficial similarities. Dragons and demons seem to be able to produce offspring with pretty well everything alive... is this because they use magic to facilitate the process, or is there some other reason? The answers to these questions could easily drive a whole campaign if they capture a storyteller's imagination, but even as side-questions, they open up new directions for a story to move.
A little more than four years ago, Dr. Eris Lis, M.D., began writing a series of brilliant and informative posts on RPGs through the eyes of a medical professional, and this is the one that appeared here on April 14, 2013. Lis is a physician, gamer, and author of the Skirmisher Publishing LLC OGL sourcebook Insults & Injuries, which is also available for the Pathfinder RPG system.