To be perfectly honest...drive letters don't really matter to Windows...other than the letter assigned to the partition reflecting the Windows install .
Every install of Windows...no matter if it's the only install or whether it is one of several Windows installs on that system...will reflect the letter C, when booted into. All other partition/drive letters (if any) reflecting a Windows install...will then change to something else.
This is because the C: designation...refers to the Windows partittion which is currently booted into. Some refer to this as the "acrtive partition" but that's really inaccurate, since any bootable partition is, by definition, an "active partition."
I'll use this system that I'm on to illustrate what I'm saying.
I have 3 hard drives, reflecting a total of 8 partitions. One partition reflects my XP install, one partition reflects my Win 7 install...the other six reflect various storage partitions (Movies, Graphics, Require Work, Warehouse, Music, Overflow).
When I installed XP, it was the C: partition. When I installed Win 7, it was the C: partition and my XP install became D:. The optical drive is E: on either install.
When I boot into the XP install, as I am now, it is the C: partition. My Win 7 install becomes D: automatically.
When I boot into my Win 7 install, the Win 7 partition becomes C:, with the XP partition being the D: partition automatically, when viewed from My Computer.
Assigning drive letters by Windows...happens automatically, there is no reason to be concerned with such.
FWIW: If you plan to do a clean install using an upgrade version of Win 7...you may have to have your old hard drive with the XP install detectable by the Win 7 install. That's perfectly normal, IME.
As for formatting the Windows 7 install...the means for doing that is included within the instructions reflected in the upgrade disk and it will be done as part of the installation process. The Win 7 DVD provides the ability to create a new partition, then format it...then install Win 7 on that partition.
Windows 7 install completes.
At this point, you have two hard drives, with 2 Windows installs (XP and Win 7). When you reboot, you will be given the option of choosing whichever you want to boot into.
If you don't want to keep the XP install hard drive on your system...just shut the system down, remove the drive...and reboot.
You may still get a boot screen that reflects the XP install...but that can be corrected by editing the boot files of the Windows 7 install...later.