First of all, this can be improved by removing ByVal, as it's the default anyway:
Public Function EncodeImage(ByVal input As Image,ByVal output As String,Optional interpolation As InterpolationMode = InterpolationMode.HighQualityBicubic) As Image
Public Function EncodeImage(input As Image, output As String, Optional interpolation As InterpolationMode = InterpolationMode.HighQualityBicubic) As Image
This could also be logically improved:
If interpolation Then graphicsHandle.InterpolationMode = interpolation
graphicsHandle.InterpolationMode = interpolation
As well as being less efficient, the first one would cause an error because you're comparing an InterpolationMode to true/false, and it cannot be compared as such.
If you're trying to set the InterpolationMode of something and it's been passed as the parameter of the function, as you've got set up already, you can just do the above to use it;
graphicsHandle.InterpolationMode = interpolation
What you may be confused about is the Optional keyword. It means you can choose to specify a value which overrides the default value, or you can leave it, and the default is used.
This means you can both of the following scenarios:
Dim myImg As New Bitmap()
Dim img As Bitmap = EncodeImage(myImg, "this is the output")
Dim myImg As New Bitmap()
Dim img As Bitmap = EncodeImage(myImg, "this is the output", InterpolationMode.SomethingElse)