How to group taxonomy terms by their parent when using term reference field?
I think Taxonomy Super Select does what you want for Drupal 6, but there's no Drupal 7 version available.

However, the module page recommends the Taxonomy Term Reference Tree Widget module to do the same thing


  This module provides an expandable tree widget for the Taxonomy Term Reference field in Drupal 7. This widget is intended to serve as a replacement for Drupal's core Taxonomy Term Reference widget, which is a flat list of radio buttons or checkboxes and not necessarily fit for medium to large taxonomy trees.