Dependent multiple selection drop down in drupal form - illegal choice error
To try take your second $form['field_policy_categories']['und']['#options'] to individual function instead of inside hook_form_alter().

function page_form_alter(&amp;$form, &amp;$form_state, $form_id) {

  if ($form_id == 'policy_node_form') {
    $form['field_department']['und']['#ajax'] = array(         
      'wrapper' =&gt; 'policy_category_list',
      'callback' =&gt; 'ajax_policy_category_callback',
      'method' =&gt; 'replace',
  );

  $form['field_policy_categories']['#validated'] = TRUE;
  $form['field_file_upload']['#validated'] = TRUE;

  $form['field_policy_categories']['und']['#options'] = categories_options($form_state);

  $form['field_policy_categories']['#prefix'] = '&lt;div id="policy_category_list"&gt;';
  $form['field_policy_categories']['#suffix'] = '&lt;/div&gt;';

  $form['#validate'][] = 'form_validate_policy_add';
}

function categories_options($form_state) {
  // option go to here
}


.