is she eating a jellyfish?

Not familiar with the Touhou 'storyline' but I think those are ghosts. Ghosts that somehow are [or are related]to the character in the BG.

Yeah. She's munchin on Myon, which is Youmu's ghost half. Hence why Youmu is feeling the pain. Funny gag but it's been done before with these characters.

In a way it's worksafe yuri.