i have iphone 4 with new update and @caitie0206 is right, it works to the volume you want it to be. like ring tone on loud volume isn't affected by when you use ipod volume. and you should also be able to play music and have the iphone shut off the music at the time you set it to.
There should be a way that you can set what features you want to vibrate. Like you should be able to set it so that if someone calls that will vibrate but if you set the alarm it will play a certain alarm sound or ringtone.