It's reconciled on the Indiana return. Indiana calculates both the state as well as local taxes on the Indiana state return. When figuring out your local tax, you are asked to provide both the county you lived in as well as the county you worked in on the interview. Your Indiana local tax will be the higher of the two county rates. (I am aware that Indiana counties do have different tax rates and I actually anticipated you are living in Indiana, because it's the only state I know of that calculates local tax like this).
Then, both the state and local tax liability will be added together, and your state and local tax withheld will be added together. If what you paid in combined for both is equal to or greter than the combined liability, you still would see a refund; if it is less, then what you owe is covering the difference your boss referred to.
Make sure that they are aware of where you live, however, so they can withhold the correct amount of county tax for you. They are actually required to do so.
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