This one took a lot of experimentation and an argument over at the Raspberry Pi Forum to solve.
Here is the link to the entire discussion: http://www.raspberrypi.org/forum/viewtopic.php?f=43&t=73174&p=527300#p527300
The stats on my final solution are as follows: I dropped the resolution down to 640x480, this produced a file size of 170k. I then dropped the quality down to 10, this is the equivalent to a quality value of 85 for most applications, and it dropped the file size down to 40k. Finally I turned off the thumbnail, which is stored as a bitmap, and it resulted in a final file size of 20k... which is what you would expect from a jpeg that size and quality settings. Here is the final command I used:
pi@raspberrypi ~/Development/tests $ raspistill -w 640 -h 480 -n -t 100 -q 10 -e jpg -th none -o vgasize10nothumb.jpg
The main problem stemmed from how Raspistill interprets the quality value. It uses it as an logarithmic-esk value where there is almost no change from 100 all the way down to 10. The the quality drops off a cliff going down from 10-1. A rather insane development decision IMHO.
As I stated a value of 10 is about the same quality as 85 for most graphics apps, which gives a good apparent quality with a very small file. And is the point of using Jpeg in the first place.