A) I'd tell the kid that that word is absolutely not an acceptable word to use, period.
B) I would certainly bring it up to the kids parents in a "your child used this language around my kids" matter of fact. How they choose to address it is obviously beyond me, but their response would certainly be telling enough for me to decide whether I will be allowing my kid to hang around with them again.
As an aside, I my general method of operation is to not often correct other peoples children, however in regard to this topic I'd make the exception. I've taken grown men to task over their use of the N word before.