Can I upgrade my xserve

If your XServe predates 2009 then it is too old to run Mountain Lion. See http://www.apple.com/osx/specs/

I would think from what you wrote that yours is indeed too old. Therefore you will need to get either a Mac Pro or a Mac mini and use that instead. My personal preference is to use a Mac mini and depending on your storage needs add to that an external Thunderbolt RAID5 system.

Over the years the ability to customize OS X Server has almost disappeared. I would like to have the Xserve 2013 (if it would've existed), pure for the 1U form factor.

But even then Apple has taken out much Server functionality like failover, not to mention the Server Admin GUI and it looks like Workgroup manager is to be deprecated in favor of Profile Manager, which essentially is not a stable product if you ask me. The only reliable services that people notice are Mail and Messages (the new iChat).

I think there will come a time in the not so distant future that Apple will only make desktop products and will leave the server marker to Linux, another Unix flavor than OS X or - given Apple's effort to integrate OS X into Windows environments - deny IT staff the luxury of working with OS X.

Upgrading to Lion is pretty safe if you still want to, just make sure you update 10.7 to the lates revision, which is 5 I believe.

You're welcome, have a great day.