I keep my XSX/PC connected directly to my AVR for Atmos/DTS:X/MA content. If Iust use VRR/ALLM on my TV for a specific game (cough cough AC Valhalla), I'll just deal with PCM as it's at least lossless and let my AVR up/downmix accordingly as that is its sole job.

Passthrough only eliminates Xbox from doing any processing prior to sending it to your audio device to be decoded. They've always had this feature for BluRay and just extended it to streaming apps. For games, we're still shit outta luck and they hopefully give us the ability for it to passthrough for other media. Otherwise, you have to change your audio settings to get Atmos when playing those games or switch to PCM for everything else.

Regarding up/downmixing, that will come to your audio device and how capable it is. If they have good codecs/matrices you should be fine. I can force DSP from my AVR in a situation like this but you might be option limited by your soundbar. I have a super old LG soundbar in a 2nd room so I can't attest to how well the newer bars fare. I see more issues with bars and Atmos on this sub than folks who have an AVR and dedicated loudspeakers, anecdotally.