"Was essen sie?" and "Was isst sie?" I believe are both correct. When I came across the question in the lesson it was in a question with a drop down that offered both essen and isst (and a third option I don't remember). I chose isst: "What is she eating?"
The clue or rule is that when you use "Sie" reffering to "you" it must be capitalized. So if it's a -fill in the blank- question, you must pay attention to the capitalization of that specific word "Was essen Sie?" or "Was isst sie?".
There are three "sie"s in German: Sie (you formal), sie (she), sie (they). The conjugation for Sie (you formal) and sie (they) is the same (essen) and for sie (she) it is isst. If they offered both isst and essen either answer should have been marked correct.
The verb needs to be the second constituent in (such) a question. A constituent can be longer than a word. For example "[Welches Buch] [liest] [du]?" - "Which book do you read?" or "[Was für eine Tasche] [kaufst] [du]?" - "What kind of bag are you buying?"