Regarding how "XP MODE" works in Windows 7

XP Mode runs Windows XP in their Windows Virtual PC, but the nice thing about it is that the programs are accessible as if they were installed on the Windows 7 system. When it's installed, you'll see the programs installed in XP Mode listed under Start > All Programs > Windows Virtual PC > Windows XP Mode. You can download XP Mode from here: (http://www.microsoft.com/windows/virtual-pc/download.aspx).

XP Mode is its own self-contained Windows XP computer (virtual machine) running inside of Windows 7.  It works much like Remote Desktop connecting to another computer, except as Dave mentioned, you can access your XP programs directly from your Windows 7 Start Menu/Desktop.

You can get the Home Premium -> Professional upgrade for as little $70, which will give you access to XP Mode.  Just like a full-blown computer running XP, updates, anti-virus, etc. are all required for this OS.

Hardware-assisted virtualization is no longer necessary for XP Mode, but if your system supports it, it is best to have it turned on.

Dave4125 is correct XP mode in Windows 7 run as a virtual PC and requires that your CPU can handle virtualization.  On the Windows 7 computer the virtual computer running XP mode appears as a Window that can be minimized to the task bar.  You have to be careful how much memory you assign to XP mode it depends on how much physical RAM the computer has.  This can be adjusted after the installation in the XP mode settings.  The XP mode installation normally defaults to 512mb of RAM but you may have to adjust that amount up depending upon your application needs running in XP mode.

The only reason to run XP mode would be if any of your applications do not run properly in Windows 7.  For example I have a client that is a golf course and they use and application that has problems when accessing the internal report writer in the application, the application works fine in Windows 7 but the reports do not run in Windows 7.  So installed the XP mode on all of their Windows 7 computers and I run the application in XP mode and it works great.

If all your programs/applications work fine in WIndows 7 then there is no need to install the XP mode.  Finally although Windows 7 may look like Vista.....it is NOT! In my opinion Windows 7 professional is a great operating system, very secure and when blended with Server 2008 in business network environment it runs great.   Microsoft got this right finally.

@PowerEdgeTech - can you please link to a reference from Microsoft that states this is the case?

I'd be extremely happy to be proven wrong as my machine isn't capable of it and I want it!!

XP Mode should work with all the editions of Windows 7 except for Starter.

It's right on the download page for XP Mode - the third of three required downloads/updates for XP Mode installation:
"Enables Windows XP Mode for PCs without Hardware Assisted Virtualization Technology."

http://www.microsoft.com/windows/virtual-pc/download.aspx

This third update is also not required for Windows 7 SP1, as it was included in the service pack.

"XP Mode should work with all the editions of Windows 7 except for Starter. "

Not true ... it is licensed only for Professional, Enterprise, and Ultimate editions.  You can download and install it on the lesser versions, but it will NOT run.

I found this, which appears to support your statement (although they still recommend having it):

http://www.microsoft.com/windows/virtual-pc/support/configure-bios.aspx

http://support.microsoft.com/default.aspx?scid=kb;EN-US;977206

And straight from Microsoft on the announcement of VT:
http://www.microsoft.com/presspass/press/2010/mar10/03-18desktopvirtpr.mspx

"They still recommend having it"  ... as do I.

Yeah, they seem to mention that running on non-HAV hardware that this fix is tuned for only XP SP3 mode.  So, if you want to run anything else on Windows Virtual PC alongside XP mode it will be less than ideal.

ALthouth there were several excellent and accurate comments, I accepted this answer because it was a little more informative and comprehensive.
THanks to all for their participation.

ccbon ... just a note about the answer that you accepted ... it is not entirely accurate:

Hardware-assisted Virtualization is NO LONGER REQUIRED to install and run XP Mode.  

Although it will improve XP Mode's performance, it is not required.  This functionality is usually off by default, so if your system is capable, you should boot to the BIOS and turn it on.  If your system is not capable, don't worry ... install all three updates from the XP Mode page, or just install SP1 before installing XP Mode.