Ways I have successfully increased use of flags on a forum I moderate:
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don’t describe it as flagging or reporting primarily – call it member moderation and use that term a lot, most active members will have at least a vague desire to be mods themselves;
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explain that a timely flag is a way to get people back on track early, so they DON’T need to be banned or suspended, and that flagging a post will not automatically trigger a sanction, but that mods will open a conversation with that person and attempt to resolve things;
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I always thank people for the flag, remind them that they are doing member moderation, and explain, as far as possible without breaching confidentiality, what action/s were taken on their flag, and why. If the flag was incorrect but done in good faith, I mention that false positives are unavoidable and that they happen to me (which is true, suspicions about members that are disproven over time, etc).
So basically invoke people’s natural desire to protect their community, especially its newer or more vulnerable members, and to see themsleves as the sheriff, so to speak, not as the guys ratting someone to the forum cops. I share this because it has increased the number of flags substantially and in a short period of time .
You could also make a tutorial for the Lounge, wording flagging as a service to the community and emphasising the protective and “member moderation” aspect.
A function that’s just sat there, especially if your community is new to Discourse, is different to a function that has been explained by someone they know and trust, and who has encouraged its use (you could include humorous examples specific to your community and funny pictures in your tutorial) so that they feel confident about what will happen, and are aware it’s expected and welcomed.
Giving new signups information on flagging means the new generation will accept “member moderation” as part of their rights and responsibilities, and you will begin to raise a new “generation” with that culture.
I’ve just begun implementing this in individual PM conversations with new members and may add it to the signup message, because so far it’s been well-received when described as a positive way to keep the community safe and focused.