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When I drag music into iTunes from the downloads folder, and then empty my downloads folder, the music is obviously no longer in iTunes because the source file was in my downloads folder.

This is on Windows 7, but I don't think that's relevant. I think it's an iTunes setting/preference.

How do I set it up so when I drag music into iTunes, it copies the music file to another folder, so I can empty my downloads folder?

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Launch iTunes then open Preferences, either from the Edit menu or by holding Ctrl ⌃ ,

In the Advanced tab, check 'Copy files to iTunes Media folder...'

This may prompt iTunes to ask if you want to Consolidate existing files. If it does, say Yes.
If not, then do it manually afterwards, from File > Library > Organise Library.

This will grab all existing files from all locations except the iTunes Library & copy them there.

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