When selecting this option and using an AD account, does Octopus add the custom account to the IIS_IUSRS local group?
I don’t believe so. It’s only setting the application pool to use that AD account to run as.
You can try to use the library step template ‘Windows - Local User’.
http://library.octopusdeploy.com/#!/step-template/actiontemplate-windows-local-user