First install Virtual PC, then XP Mode. Both installations are straightforward and the default settings will suffice for most situations. When XP Mode setup launches and you'll need to supply a password for the local XP Mode user that XP Mode automatically creates on the virtual machine. Finally you'll need to decide whether or not you want automatic updates. After all this information is gathered, Windows will finalize installation of XP Mode.
When installation is complete XP Mode will launch in Desktop Mode. Here, you have access to the full XP environment. Desktop Mode is useful when you want to use a completely separate desktop environment from your Windows 7 base install. It's important to note that by default, shortcut keystrokes are only passed to XP in Desktop Mode when it's running in full-screen. Also, while you don't have drag and drop capability between the operating systems, they do share a clipboard. Also, you have access to the complete host file system while in Desktop Mode.
Virtualizing Apps with Seamless Mode
Where XP Mode really shines is with Seamless Mode, which lets you launch XP apps straight from your Windows 7 menus. To use Seamless Mode, you first install an app under Desktop Mode, then log out of and close the virtual machine. The app you just installed can then be found on the host PC's Start menu under All Programs, Windows Virtual PC, Windows XP Mode Applications.
When the app is launched from the host OS, XP launches in the background and the app appears as if it were running natively in Windows 7. Apps run this way are called virtual applications. If you don't find the default start menu location to be convenient, you can move the shortcut to any location a traditional shortcut can be placed. If the app you want to virtualize doesn't automatically create a Start menu shortcut, or the app is already included with Windows (Internet Explorer 6.0 for example), you simply need to create a shortcut for it in Desktop Mode under c:\documents and settings\all users\start menu and the app will appear on the host start menu under Windows XP Mode Applications.