I have never understood this feature, I have used it many times and I have always seen the same results. The "defrag" always takes, like 3 seconds then it tells me that everything is fully optimized. I have even done this with a brand new freshly downloaded game that I know the files will be scattered all over my harddrive. I will use the defrag option with the newly downloaded game and it will say the game is fine, but if I use my regular defrag program I see that it is fragmented. I have never even seen a "progress" bar for this steam defrag option. Am I using this incorrectly? If my regular defrag program shows that the game is fragmented, why does steam tell me nothing of the sort?

Difference defrag apps show different things, like the Windows one says your drive isn't fragmented yet Pinriform defragger says it is. Generally you shouldn't worry about it because modern drives and NTFS now days minimises the effect of fragmentation.

The .gcf files are similar to their own filesystem/drive, and can get fragmented like one - but they themselves are stored on a filesystem, and can get fragmented on that filesystem.

The Steam defragger eliminates any fragmentation that accumulates internally in the game cache files. The system defragger ensures that the cache files themselves are placed contiguously on the drive. You need to run both to be absolutely sure all the files are defragmented internally and externally.