Hello simmray
We stayed in Hostal Martin/Cervelo (2 adults, 3 children) and thought it was great.
If you do a search of this site (top right of page) and use the words Hostal Martin or Hostal Chelo you will get lots of info on them. Also if you just type in Hostal Madrid Family you will probably throw up something too.
Here is one of my bits about Hostal Martin/Cervelo, but you will find many more.
Hostal Martin/Cervelo for family I'm sure you wont have a problem finding something to suit your needs.
Jo