Well, exp can't be dropped as loot, so you'd have to use items for that (e.g. items giving exp on use), or maybe spawn custom prefabs in the combatant's death event. The prefabs could add exp to the combatant.
The Auto level up mode will collect the (selected) exp for the equipped weapon when the combatant receives the exp. So, even if your combatant doesn't level up, you can still set up an exp status value (using the None experience type) to be used for the weapons.
Yes, upgrading a weapon into a different weapon can be done via equipment variables.