It shows as an image on the browser address bar. The ico image needs to be on the root server directory.
Note that this file is really sticky when it comes to cache, meaning that if you hit your site and then edit and upload a new version, the old version will display even after you have clear cache and close the browser. It happens to me in chrome and firefox. The best way to get the new version is to actually hit the icon directly: http://yoursite/favicon.ico It looks like after that the browser realize there is a new version, and updates itself. Hope it helps some out there where changes in the icon don’t seem to translate in changes in the displayed icon. It drove me nuts for awhile…
This site does an excellent job creating icons online on-the-fly with some customization: http://favicon.htmlkit.com/favicon/