It will update the atlas when you add new art into those folders, its the easiest way to add new art to the atlas.
For your settings you want to set a max texture size that will encompass all your sprites into one texture or as many as you can. The less textures you have the less draw calls you have. That setting is for the atlas texture(s) and not the sprites.
That is the theory. If the sprites have transparency and don’t take up the whole 1024x1024 it may fit more with tight packing and or allow rotation enabled.
This to me is an oversight on Unity’s part. You need to create your own custom atlases.
Due to the nature of how normal maps work, they need to occupy the same texture space as the sprite. This means that if the sprite is at 32,32 on the sprite atlas, the normal map for that sprite needs to be at 32,32 on the normal map atlas.
With a SpriteAtlas it automates the positioning of the sprites so the position on the texture is not guaranteed to be the same on both the color and normal map atlases.
What Unity needs to do is make a normal map option for the sprite atlases, this way you can have a sprite named wall and then name the normal map for it wall_n and it will use the color atlas position of the sprite to position the normal map sprite.
SpriteAtlas now supports additional/secondary maps for Sprites. You can specify secondary textures in the SpriteEditor and SpriteAtlas should automatically generate Normal Map Atlas. Please make sure the position of the Sprite and its Normal Map is the same as well as the Texture Size are the same in the source Assets .
Both the bump and normal maps are in the same folder that contains the sprite, they are added to the sprite. What I did is creating the atlas by dragging the folder that contains both the sprites and their secondary textures, but, as you see on the image, they do not display in play mode.
It’s a bug in the editor. I just got the atlases using the secondary textures when I tested a new object and the normal maps worked. It never happened again though.