This isn't probably really used much these days, but yeah, it was/is called Overlay mode.
The graphics card isn't necessarily decoding the MPEG data (though that could have been an option in the olden days too), but it is likely scaling it and spitting it out in the given-colored pixels faster than you could've done with just software back in the days.
The AVS visualizer for Winamp also supported this; if you set the overlay color to black, you could have all of the black text on your desktop be very, very funkily animated.