The Alchemy system can only be used after you obtain the Alchemy Pot from King Trode on the boat after defeating Khalamari. From then on you can use the Alchemy Pot by accessing the Miscallenous section of the Menu. To use the Alchemy Pot, you need to select two or three (Three Once You Upgrade The Pot) from your inventory. Then, a display should tell you whether you have a good combination or not. Then If you want to use the Pot, then exit from the inventory, and walk around, and then eventually you should hear a bell sound, then go back into your inventory and the item with be finished.