$\frac{1}{y}(dx^2+dy^2)$ is shorthand for $\frac{1}{y} (dx \otimes dx + dy\otimes dy)$. This is a bilinear form on the tangent space (Really it lives in a tensor bundle but this seems a bit grand for such a simple object). It eats two tangent vectors and spits out a number, and this assignment is linear with respect to each of the two tangent vectors.
Explicitly, if $\begin{bmatrix} x_1\\y_1\end{bmatrix}$ and $\begin{bmatrix} x_1\\y_1\end{bmatrix}$ are tangent vectors to the upper half plane at a point $(a,b)$, then $\frac{1}{y} (dx \otimes dx + dy\otimes dy) \left( \begin{bmatrix} x_1\\y_1\end{bmatrix},\begin{bmatrix} x_2\\y_2\end{bmatrix}\right) = \frac{1}{b} (x_1x_2+y_1y_2)$.
In other words, this object is telling you how to take a ``dot product'' in this new metric, and in this case it is the same as the regular dot product, just scaled by the reciprocal of the ordinate of the point that the tangent vectors as based at.
Once you have a dot product on tangent vectors you can do ``geometry'' locally. In particular you could talk about the length of a tiny line segment using this dot product. So when computing the length of a curve in this metric, you integrate all these tiny lengths.
BTW I think you probably meant to write $ds^2 = \frac{1}{y^2} (dx^2+dy^2)$ if you want hyperbolic metric on UHP.