A subtle expression of disbelief at someone being totally blind to the self-delusion in what they've just said.
Echoes the sound of "That's OK then", and is usually used ironically.
It's not homophobic, but is a response to people saying things like "I slapped DeepHeat (Ralgex, Wintergreen, ...) on my mate's wedding tackle. It wasn't gay because it was in the showers after football practice".
See, eg, Flap Jacks
for further examples.
A: I just ran someone over in the street, but it doesn't matter because they were already in a wheelchair.
B: Well, that's not gay then.
Politician: Military deaths in Afghanistan/iRaq have reached X, but civilian deaths don't count.
Political commentator: That's not gay then.
A: I 69'ed my mate yesterday, but it wasn't gay because we both spat it out.
B: Actually that was a bit gay of you. Nearly as gay as a treeful of parrots. You couldn't get much more gay without donning a backless gimp suit
and chaining yourself to a lamp-post outside a gay nightclub in Gayton at closing time.
A: I gimp-suited up and handcuffed myself to a lamp-post, but it wasn't gay because I was drunk, and anyway I had my fingers crossed
at the time.
B: 'Nuff sed.