This problem is addressed in ArcGIS 8.1 Service Pack 1. See the Related Information section to download this pack.
The default search radius for the Density function is always shown in the units for the data frame's spatial reference. If the output spatial reference is set to be the same as the input’s (via the General tab of the Options dialog), then the units for the default search radius should be in the units of the input's spatial reference, not the units of the data frame.
This is a known issue with ArcGIS 8.1.