downlo:

The best response to a racist joke should accomplish 3 things:

1. Communicate that you find this behavior unacceptable.
2. Demonstrate that the joke is racist.
3. Inflict as little damage as possible to your […] relationship with the joker.

So how do you respond when a coworker (or someone else you have to maintain a relationship with) tells a racist joke?

The best strategy is to play dumb.

Put on a bewildered expression, act as if you don’t understand the joke, and ask your co-worker to explain it to you. He will not be able to explain why the joke is funny without evoking a racist stereotype. You can then question the veracity of this stereotype, thus pointing out the racism of the joke, without being confrontational and without humiliating your co-worker.

[…]

Racist jokes rely on an unspoken, shared knowledge of racist stereotypes. Without the stereotypes, there is no humor.

When you play dumb and ask someone to explain the joke, you are able to draw the racist stereotype out into the open, address it directly, and demonstrate how absurd and offensive it is.