This is all about propaganda. It's highly significant that they had held on to this guy for some time, but chose to kill him in this highly theatrical fashion when the abuse/torture scandal was full blown.

Another angle: Do we even know how many Americans, not to mention Westerners, are held hostage now? Remember the way the Iranians taking the US Tehran embassy staff hostage had completely paralized the Carter administration? BushCo wasn't going to repeat that mistake. They just ignore or downplay any hostages in Iraq. So decapitation is one of the few ways that Iraqis have available to point out that they are holding Americans captive.

Dose BushCo even bother to determine what Americans are being held hostage by Iraqis? Not that I am aware of. It's bad P.R.