up load it to your media and in the URL option put the location of the image i.e. mine is http://localhost:51792/wp-content/uploads/2012/02/favicon.png
If you cant find the url you go to media find the image and click edit it should have the url link there
PS the favicon option is in:
Graphene Theme Options >> Display Options >> Miscellaneous Option >> Favicon Options
Hope this helps