Firstly, I get the feeling it isn’t a much used tool in blender, is there something better I’m missing?
My actual question is why it only works in flat shading mode, and if there is a way round this? It would be a lot more useful to be able to gauge its impact on the mesh in smooth faced mode, so that you could see when it becomes too greater reduction for objects?
Ts
Typing this on my new sexy razer blackwidow keyboard… 
Well you can always apply the modifier and then shade smooth.
I don’t know what others use it for but I find it very useful when creating rocks. First I sculpt a random high resolution object to the shape I want the rock to be and then use the decimate modifier to give it a nice rough look.
I also used it in a short animation some time ago to get the artistic style I wanted: https://vimeo.com/20326263
One of the use i could think about it concerns when you model for a game engine.
For performance optimisation, one of the most widespread method is using level of details, basically a bunch of lower and lower poly version of the main model itself.
But unfortunately, the decimate modifier is not very good for that as it utterly destroys the UV, considering for performance reason every LODs use the same texture, it’s very very bad then as you’ll have to re-unwrap every LODs to fit your original texture manually.
Better use then the Pöly Reducer script from Blender 2.49b , so much more usefull than the Decimate modifier, as the Poly Reducer tries to keep the UV and weighting intact.
If the question is for me, yes that’s exactly why i was mentionning “level of detail” models, but in that case check the much superior poly reducer for 2.49b that does the same but preserve UV and weight :
http://wiki.blender.org/index.php/Extensions:2.4/Py/Scripts/Mesh/Mesh_poly_reduce