Upgrading - Incremental or All at once?

You should replace your system folder with the latest version. And then follow all steps and replacing your files in application and doing the modifications.

Have you modified the system folder? As it shouldn't be that many edits in the application folder, those don't really alter your application.

Do what you feel best works for you, there are no right or wrong (but 1 goes faster).

I don't see how you would end up diffing your files 11 times with option 1, option 2 however... As you make a note on what files to replace in e.g. 3.1.1 and if it's replaced again in 3.2.1 you apply the 3.2.1 one.