Yup, DW does have a reasonable amount of photo hosting space. Uploading to your gallery is just completely separated from blog posting, so you have to upload first, then grab the embed code (the html is provided in a little text field, if you don't have the tags memorized), then go back to your draft and drop it in. It's not hard, just tedious compared to all them newfangled websites.

You start with the "Upload Images" link in the "Create" dropdown menu at the top of the page.