Neither as far as I know, it just tries to emulate XP by changing a few settings. Sometimes it works, sometimes it doesn't.
Actually what you are thinking of is compatibility mode.
XP mode is a virtual XP install that runs a full blown xp virtual machine. Once setup the programs run in a seamless window that makes it seem like its running natively.
I have used this for some legacy apps that run under xp but not windows 7
For gaming, it depends. If they run fine under xp without 3d acceleration you might be able to use it, if not the only option would be to dual boot, but you cannot use the xp mode do to that you would have to have a valid license for xp