Minimum volume size for FAT16

Yes, Windows XP and Vista can still read/write FAT16-formatted hard drives.

I have several external hard drives formatted in FAT16 and have never had a problem reading or writing to any of them with Windows XP and Windows Vista (and Windows 7).

It has become more common (again) to format drives using FAT16 so they can be used with some external devices. I use mine to plug into a DVD player with an external USB port. I still have to read/write the files from Windows XP/Vista/Win7. No problems.

You may use EASEUS Partition Master Home Edition to partition the key.

EASEUS should be able to format in FAT16.
If it cannot, see How do I format at USB Flash Device to be FAT16?, where the tool to is:

FORMAT drive: /FS:FAT16

(don't use the wrong drive-letter!)

Just be aware that for a partition greater than 512MB, you will only be able to store 512MB in any one folder.

You don't need to worry about the BIOS, since booting is from the hard disk, not from USB. In any case, partitioning the USB will destroy all data on it, and the BIOS does not live on the USB.

If Windows cannot detect the USB, see the advice in Windows Can’t See USB Hard Drive.
If that doesn't help, see A computer that is running Windows XP cannot detect a USB flash drive.