Kids will do anything that gets a reaction. I don't think that type of play is abnormal, we used to play with doctor sets all the time when we were young and our favorite thing to play was operation where we'd "cut" the patient open and then pull out all sorts of funny things hidden under the shirt (we'd stuff our shirts with funny toys). We were normal, non-violent kids.
I think the mother made a normal mistake in trying to play along. The thing is the kids got the reaction they wanted so they kept doing it. If she had squashed the action from the beginning, it wouldn't have gone on for 10 minutes. She was probably trying to be extra-nice because she was in front of other people, and in doing so the kids just kept walking all over her. Her first mistake was playing along, they kids wanted to do anything to keep her playing along.
I don't think the play has a purpose other than causing a reaction. You can get a child to do something positive or negative by giving a reaction to it, especially at that age. They're not thinking of actually cutting, they're looking for attention. When I worked in daycare I learned quickly that to give a big negative reaction to something was just as bad as giving a big positive reaction--and that as soon as kids saw one kid getting a lot of attention, the others were quick to follow. So if a child did something negative (like pretending to cut the teacher) even if it was done in innocent play and for fun, I would probably calmly and quietly confiscate the play knife and say gently "we don't play that way." If I made any bigger deal out of it than that, I'd have a bunch of kids running over with play "knives" laughing and trying to cut me.
You can turn that around any way because if one kid came over and offered me play fruit and I said "Yum, thank you!" and pretended to eat it in a funny way, I'd also have all the kids running over to me with play fruit trying to get me to eat it in a funny way.
So bottom line, don't react to negative play behavior. Squash it quietly, calmly and gently.