When people ask for realism in fantasy games, what they mean is usually not realism in the sense of having a realistic setting, as in, not having elves or magic or anything like that, asking for thatr in a fantasy game WOULD be kind of silly because that would be completely missing the point. What they usually mean is that things are handled in a way that is realistic, where real life logic is applicable. Sure, in a fantasy world, we may have magic and dragons and what not, but that doesn't mean characters still can't have needs like eating and drinking, for example, or that getting hit by a sword wouldn't have a similar effect on someone to what it would have in real life. Therefore, characters needing to eat and drink in a fantasy setting is realistic, now when characters can get hit by a sword ten times and still keep fighting, that's unrealistic, although not necessarily implausible if the game gives an explanation for why your character can do it. If you look at it another way, while things like magic are technically unrealistic, they're departures from real life that are part of the story or setting, on the other hand, things like being able to carry an unrealistic amount of loot are aspects of gameplay that are not meant to reflect an actual aspect of the setting, usually when people ask for realism in games, it's more realism in that respect that they are refering to. Realism may also refer to the overall feel of the game or its visuals, just because your humans live in a world of elves and unicorns doesn't mean they can't be made to look like real humans. For that matter, even when designing the fantasy aspects of a setting, the designers can ask themselves "What might elves look like, if they existed in real life?"
For me, it really comes down to a question of what makes for the most entertaining game, because entertainment is what I play games for, not for a simulation of whatever the game is about, sometimes, a bit of extra realism can add to that, in which case, it's welcome, but just because something is realistic doesn't automatically make it a good idea, some things that are realistic would just be annoying and would detract from the fun of the game. For example, most of us seem to agree that requiring the player to find a toilet would just be unnecessarily annoying. I'd argue that mandatory eating, drinking or sleeping are the same myself (I'd also argue that requiring the player to eat and drink but not following it up with what logically follows is unrealistic too.), but some actually want that in a game, on the other hand, the need to answer a "call of nature" is something that even they do not ask for, so I think it's an appropriate example. Yes, it's realistic, but is it wanted? I'd say no. Needing to do it would not be fun and would not even add any sort of meaningful challenge to the game, it would just be an annoying chore, and that's usually something games seek to avoid, on the other hand, location damage is arguably realistic, I mean, the way it's implemented in games isn't always fully realistic, but the idea that depending on where you get shot, it would have a different effect on you (Which in games usually means that getting hit in vital areas does more damage.) fits in with reality, and that's not something I've ever complained about, aside from realism, it can add an additional element of strategy to combat, especially if aside from different amounts of damage, hitting people in different locations could potentially have other effects, such as shooting them in the arm potentially making them drop their weapons, as you could potentially choose to trade off dealing additional damage for reducing enemies' threat level or making them easier targets. Adding realism to a game can potentially be good or bad depending on the nature of whatever realistic feature you add, it can also depend on the game. Some games just don't lend themselves to being realistic, and having some realistic aspects could actually become awkward because it doesn't mesh with the rest of the game. And yes, I know that by that logic, we could potentially have a game where the examples of undesirable realism I gave could actually be beneficial. however, it would be hard to name examples of games I've played where I really felt that such realism was an important part of what made them work. Thus before developers add a feature simply because it is realistic, they must ask themselves certain questions, is it actually fun? And does it fit the game?
...of course, over in the "need more gore" threads, they're arguing "realism" for MORE gore. ("If I hit someone with a sword, there should be cuts / slashes / dismemberment / etc, not just some blood splash!")
There WOULD be cuts and slashes if you hit someone with a sword, though, you wouldn't need to have seen someone actually getting hit by a sword in real life to know that. I'm sure we've all been cut with sharp objects before, they don't have to be swords, anything sharp will do, if that happens, the object doesn't just pass through you, leaving no visible damage but still drawing blood, which is exactly what getting hit with swords and other weapons did in Morrowind and Oblivion, it would leave a cut, it could be a deep cut or a shallow cut, a large cut or a small one, but chances are you could see where you got hit by the weapon.
Now, outright dismembering limbs on a regular basis might not be realistic, not because limbs CAN'T be severed by a bladed weapon, but because it would be very difficult for it to happen in a regular combat scenario, but the "gore" in Morrowind and Oblivion, at least, is certainly not realistic.
Though when it comes to blood and gore, I don't need or even necessarily want it to be completely realistic, I just want it to be believable, it wasn't believable in Oblivion because there was no sign of any visible damage to characters who were killed with bladed weapons, once the blood faded, they looked like they might as well have died of poison, but Fallout 3's was not believable either because it went in the opposite direction, being too over the top to be plausible, being a little over the top isn't always a bad thing, but when you want your setting to feel completely realistic (Fortunately, I don't consider Fallout all that realistic to begin with and don't ask that it try to be.) having people's heads taken cleanly off by pistol shots is not a good idea. In the end, though, for a "realistic" game, I don't need the gore to be completely realistic, as long as it doesn't stand out as implausible, it works.