tl;dr
Yes it's the correct way.
But to be more precise: Yes, it's the correct way to allow .htaccess to override all directives in the /var/www directory.
As you found out, AllowOverride is allowed only under the Directory section.
Using your example:
<Directory "/var/www">
AllowOverride All
</Directory>
This is telling apache, that all configurations can be overridden in the /var/www and all its sub-directories (recursively).
For a better example, consider you have the following configuration in your virtual host:
<Directory "/var/www">
AllowOverride All
</Directory>
<Directory "/var/www/uploads">
AllowOverride Limit
</Directory>
And the following directory structure:
var/
www/
.htaccess
uploads/
.htaccess
a/
.htaccess
b/
.htaccess
code/
.htaccess
c/
.htaccess
d/
.htaccess
What I did here, is create an .htaccess in every sub-directory of the /var/www directory.
It usually shouldn't be like so, but this is just for the sake of the example
Comparing the directory structure with the configuration, it means that all .htaccess files inside in the /var/www folder and its sub-directories, excluding the /var/www/uploads directory and its sub-directories, can override all kinds of directives.
But /var/www/uploads and its sub-directories can only use the .htaccess file to override the Allow, Deny and Order directives.
Note: As of apache 2.4 (Which is available by default in 13.10+) the Allow, Deny and Order directives were replaced by a single directive named Require.