The on hit level really doesn't do anything. KT uses a custom weapon script I developed to get around Bioware's 20 point damage limit. That is, it limited you to no more than 20 points of damage of any type.
My system is based on the d8. The 'on hit' level is only a descriptor and does not actually do anything. I think there are some items that still say level 1 even though they do much more damage (if you see something like that, please let me know).
The actual damage amount is based on the base damage I assign (1d8, 2d8 or 2d12) plus a code I put on the weapon (either manually or by script when you enchant a weapon). The "on hit" level is calculated by adding the base damage to the extra damage dice.
For example, a weapon with only 2d12 of base damage is considered a level 3 weapon. It won't do any extra damage beyond the 2d12. A level 5 weapon will do 2d12 plus an extra 2d8 of damage. The custom script deducts the base damage from the extra damage when calculating level.
Now you might wonder why I did it that way. Why didn't I just eliminate the base, traditional Bioware damage altogether and do all the damage using my custom script? Well, critical hits only affect base damage. They do not and cannot affect the extra custom damage, because I have no external method in software to determine if a critical hit was scored. The core melee scripts aren't accessible. They are hard coded into the game machine (at least I have never found a way to get into them).
So, I mix and match my custom system with the base damage so that your weapon will do more damage on a critical hit. This has a side benefit (in my opinion) of reducing the damage dealt from critical hits, which I think are overpowered in the original game. Another side benefit, I used to have to put multiple damage types on weapons to make them effective at higher levels, pretty much making one weapon that would do it all. Now I can put lots of one type of damage on a weapon, making it effective against some monsters but worthless against others. This forces characters to actually develop and use more than one weapon, something I think makes the module more interesting.
Bottom line: the level is something I put on the weapon so you know how many total d8 of damage it does, but the level does not actually have any effect. I think level 30 is about as good as you can get right now, not counting upgrades.