By design Exchange Online(O365 Exchange Hosted organization)will look up first on the object in the cloud directory and accepted domain setting below will follow accordingly.
Authoritative: Email will be rejected right away if the object is not on cloud directory
Internal Relay : Email will be routed to the connectors to see if the object is found on the on-premise directory
Caution: Message routing topologies and settings, especially for hybrid configurations, can be complex. Even if changing the Accepted Domain setting fixes the bounce message problem, it may not be right solution for your situation. In some cases, it may even cause other unanticipated problems. Please review Manage accepted domains in Exchange Online and then proceed with caution.
If you’ve set up a hybrid configuration (some mailboxes in the cloud and some mailboxes on-premises) and the Accepted Domain for your domain is set to Authoritative, Office 365 Hosted Exchange Organization looks for the recipient only in your cloud directory. If the recipient is on-premises, and you haven’t added the recipient to your cloud directory (either manually or via directory synchronization), the look-up fails, and the sender may receive this bounce message. If the Accepted Domain is set to Internal Relay, Office 365 first checks your cloud directory, and if the recipient isn’t found there, it routes the message to your on-premises mail servers (assuming you’ve correctly set up a required mail flow connector to do so).
Warning: When setting Accepted Domain to Internal Relay, you must set up a corresponding Office 365 mail flow connector to your on-premises environment. Failing to do so will break mail flow to your on-premises mailboxes.
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